This is more of a practical paper than my last one, giving a quick overview of the uneven success enjoyed by fast food companies in China, and offering a series of prescriptions designed to avoid some of the more serious rocks and shoals, and mitigate the effects of many others.

Walking the floor at both CES in Las Vegas and Electronica China in Shanghai within a ten-week space provides one with a clear view of how far Chinese enterprise has come, and, equally important, the degree to which international technology businesses have lost their former dominance in China.

One could conclude from these impressions that multinational tech companies are in a state of permanent decline in China: Beijing’s unstated but ongoing policy of import substitution has succeeded, and foreign companies are fighting a losing battle. You don’t need to go to trade shows for anecdotal evidence. Just look in purses and backpacks: ZTE, Huawei, TCL, Lenovo, and Yulong are five of the top ten mobile device brands, and they’re gaining on the global giants.

But if you dig a bit deeper, as you can at a show like Electronica, you find that the opportunities for foreign tech companies have not disappeared: they have evolved. To understand why and how, it is useful to start by looking back on how the tech business developed in China.

From Buy to Make

Since the beginning of reforming and opening in China in 1978, the nation has essentially gone through three phases of foreign involvement in technology-based industries.

The first phase was imports, when the government focused on bringing urgently-needed products like personal computers, telephone switches, automobiles, machine tools, and other technology-based products into China. The need for these products, most of which were essential to ease key bottlenecks in the development process, was so urgent that key ministries were permitted the use of precious foreign exchange to purchase those goods.

China’s leaders always expected, however, that the nation would begin producing these goods on its own, preferably in local companies, but realistically in joint ventures with global technology companies who would bring three essential ingredients: the products, with their component technologies; production know-how, with process technologies; and the capital to build the production facilities. This was the second phase: the shift to local production.

Fast Followers

By the mid-1990s, though, another shift began to take place. As the global tech giants ramped up production in China to a mass-scale, local firms began manufacturing their own technology goods. Local firms began to dominate production, using a “fast-follower” approach: “maybe we won’t be innovators, or even the first to market with a given innovation, but we will come to market so soon after the innovation leader that we will still reap our share of the market.”

By last year, the payoff of this shift had become apparent. Chinese high-tech companies were long past needing foreign manufacturers to teach them how to build high-tech products, to help them implement cutting-edge production processes, or even to finance the construction of factories. Those local firms unable to bootstrap their own capabilities and finance now had a vast stable of local and foreign companies ready to provide the necessary technology, and finance, thanks to cash flow and capital markets, was no longer a problem.

Innovation, however, remained a challenge. While a handful of local tech companies – notably (but not limited to) Huawei, ZTE, Xiaomi, and Leovo – had begun to innovate, widespread innovation that would offer a more sustainable competitive advantage (and a larger share of profits) still seemed a ways off.

Enter the Innovation Platforms

And there it remains today.

This gap between efficient production and value-driven manufacturing is the heart of the next opportunity for foreign firms. While the days of foreign brands utterly dominating technology markets in China may be past, more than ever China’s manufacturers need a steady stream of innovations upon which they can base their own innovating.

Technologies that serve as the foundation that allows others to innovate are what we can call innovation platforms. Five factors make innovation platforms stand out from other technical advances:

Significant – The core innovation is a genuine advance that is both useful and relevant;

Substantial – There is a obvious, large, and diverse market for products based on the innovation that offer substantial profit potential, and the technology is easily commercialized;

Shared – The company promulgating the core advance is more interested in creating an ecosystem than a monopoly, i.e., it is content with focusing on supporting and enhancing the core technology and not getting into the business of its customers/licensees;

Stable – Any subsequent changes in the underlying technology are likely to be iterative, not major, for several generations of products. This makes it economically viable for companies to invest in R&D based on the innovation platform.

Supported– Rather than serving as a glorified patent troll, the companies that develop innovation platforms invest heavily in resources designed to assist product developers create viable commercial products, such as on-site engineering support, system validation labs, extensive documentation, or developer groups. In addition, the company continues to invest in improving the core technology.

Early Innovation Platforms

Many innovation platforms take the form of acknowledged industry standards. Examples like Wi-Fi, Bluetooth, and USB could be considered a form of innovation platforms, in that their technologies enabled the creation of products and even companies.

But when we talk of innovation platforms, we are really looking at products and technologies that spawn not only products, but companies and entire industries. Some illustrative examples:

The Xerographic Process: Invented by Chester Carlson and later commercialized by Haloid/Xerox, which begat the photocopier, the laser printer, desktop publishing, and many specialized sectors;

The Intel 8000 microprocessor family, that together enabled the creation of the personal computers, stand-alone video games, and a half-dozen major industries;

Qualcomm’s CDMA: CDMA enabled the commercialization of the internet, created the telematics industry, and is on its way to recreating the automotive, trucking, and healthcare industries, among others.

Each of these companies took an indirect lesson from the failure of Thomas Edison’s Motion Picture Patents Company, an industrial trust that tried to control the film business as well as the manufacture of cameras and film stock. It was, arguably, Edison’s greatest failure. By exercising a modicum of control over the core technology, supporting it, advancing it, and making it available on reasonable terms, Xerox, Intel, and Qualcomm each fostered the creation of immense economic value.

Platforms for the Future

In a world where industrial and engineering capability is a scarce quantity, the easiest way to make a return on a major innovation is to create a vertical industry around it, building the components, creating the product or system, and distributing it under your own brand. The Bell System did this for nearly a century with telephones, and IBM and a handful of other companies did this for the first three decades of the computer industry.

But when the ability to design, engineer, and industrialize complex products is widely distributed, as it is today, robust companies are built on either using innovation to enable industries, or in building on innovation to create industries.

For the time being, Chinese companies are (generally) comparatively better at building industries based on key innovations, and European and particularly US companies are (generally) comparatively better at consistently creating core innovations that can serve as the platforms for those industries. This does not mean that no core innovations will come out of China, or that the US is no longer capable of product development and commercialization.

But it does suggest that the richest opportunities in China for foreign companies, particularly those in science, engineering, and technology-based industries, lies in licensing and enabling Chinese manufacturers, rather than competing with them.

The question facing tech companies, then, is whether and how to make use of the company’s innovations – or an ongoing stream of them – in order to serve as a profitable and indispensable platform for Chinese innovation. And for those of us who watch this market, the pressing question is “in which industries will the next round of innovation platforms emerge?

I leave the first question to the companies themselves. For the second question, my early research points to transportation, healthcare and biosciences, construction, energy, and the environment. I know: I have my chips on a lot of spots on the roulette table. In the coming months, I look forward to sharing with you why I think things are going that way.

The issue of intellectual property rights and their protection continues to bedevil the agenda between China and the rest of the world. Do Chinese companies cheat? Certainly many do. Does China have on the books a comprehensive set of intellectual property protection laws? Without doubt. Does the government act to protect the IPR of foreign companies? Not as much as they could. All indications are that this situation will continue for at least the foreseeable future.

For that reason, it is perhaps past time to start drawing bigger lessons from this situation. It is time we started approaching IPR less as inventors and their attorneys, and more as businesspeople.

To that end, I propose six principles of what I call “entrepreneurial” IPR protection in China. Lawyers and the like are essential to the IPR protection process, but experience in China has proven that legal protection is insufficient. In addition to having legal eagles at your side, you need to take your own steps to protect yourself.

1. Start by protecting the rights of others. Remember that if it is all about you or a small subgroup, you are going to lose in the name of the greater good. The more protection benefits everyone, the more it benefits you.

2. Make it about citizenship. Actively support the creation of an IPR protection system that serves the interests of all parties, including the public at large.

3. Look inside before looking outside. Do all you can in your internal processes to protect your rights. For example, if you are walking around with a laptop that is not using disk-level encryption, but you pay for a high-power IPR attorney, you are doing this all backwards.

4. Don’t be an IPR troll. Protect only what you must. License what you can. Give away as much as possible.

5. Be a wellspring, not a storehouse. People will support your IPR if they depend on you as a source of innovation more than they depend on the innovations themselves. Remember that the well is more valuable than a bucket of water.

6. Talk about what you are doing. When you are being smart about protecting your IPR outside the court system, talk about it. Each of the steps above will brand you as smart, forward-thinking, and the kind of company people will respect. If nothing else, all of that reputation capital will serve you well when you are forced to take the nuclear option and drag some beloved Chinese company into court, as it strengthens your case politically (and make no mistake – court decisions in China are political.)

In the case of many companies, there are even more steps you can take that are specific to your industry or situation. This list, however, represents a set of general prescriptions and a place to start in rethinking your approach to protecting your IPR in China.

If you have been following the news, you will have heard that a U.S. Congressional committee has issued a report urging U.S. firms not to do business with either Huawei or ZTE. Those two companies, respectively the second- and fifth-largest manufacturers of telecommunications equipment in the world, are accused of a range of offenses. In my opinion, the real offenses for which those companies have been placed in the Congressional mush-pot have little to do with the reasons outlined in the Congressional report. The companies real offenses are:

They are from China, and this is an election year;

They are the first companies in 70 years to challenge American companies for dominance in a core US industry that have not been from an ally or a client state;

They have failed to be sufficiently transparent when doing business in a country that demands transparency from all companies, and even more from those that hail from competitor economies.

If Huawei and ZTE are guilty of anything, it is that they have built their U.S. businesses and ambitions before they have laid a foundation of trust with the American public and its elected officials. Ideally, no company should have to do that as a prerequisite do doing business in America, but trust is the price for any company stepping into a new country. The two companies are learning a lesson that must be absorbed by every Chinese company expanding overseas. China as a nation may or may not be successful in its efforts to reform the global system to suit its ambitions. Even if it is, though, Chinese companies must still conduct themselves in a manner that is acceptable to the governments and consumers in the markets they seek to enter.

At the same time, there is also an effort underway to tar Huawei and ZTE as a malevolent presence in the telecommunications industry, an effort that steps beyond fact and into the realm of speculation and rumor. As I noted in Making the Connection: The Peaceful Rise of China’s Telecommunications Giants, it behooves both the U.S. government and the U.S. telecommunications industry to stop relying on politics and the F.U.D. pump to preserve their markets. Instead, it is essential that American companies focus on Huawei as a competitive threat where it counts: in the market. A failure to do so only postpones their inevitable implosions.

I’ve spent much of the morning talking to reporters about the report, so I won’t belabor this. If you are interested in some balance about the issue, I talked about this this with Kaiser Kuo, Jeremy Goldkorn, and Will Moss on the Sinica podcast recently. Take a listen – I think the podcast covers the issue far better than 60 Minutes did. For a more U.S. policy-oriented viewpoint, I also covered this in The Pacific Bull Moose, my U.S. politics blog.

Another myth worth busting is the notion that China is responsible for all of the world’s counterfeit problems. Counterfeiting is truly a global problem. According to Research And Markets, China is the top source of counterfeit electronic components; approximately 10% to 40% of electronics goods in China today are believed to be fake. Yet the estimated figure across the Middle East is 20% to 40% and across Eastern Europe, 10% to 40%. Other Asian countries—including Korea, Vietnam, and India—and some South American countries significantly contribute to the overall intellectual-property-infringement problem.

As most of us learned by the time we were seven, the worst possible defense for any offense is “yeah, but they’re doing it, too.” But that is not the intention of the author of the piece. The point is simply that the matter of counterfeits does not begin or end with China, and that a focus on China as the intellectual property rights-violation poster-child can lead to policies that don’t solve the problem.

The counterfeit problem is a trans-national, cross-jurisdictional matter that is confounding law enforcement authorities worldwide because the networks that drive such trade operate beyond traditional jurisdictional boundaries. The persistent belief among both brand owners, many of their attorneys, and the general public is that IPR violations in China would go away if the cops would just do their job. There is some truth in that, but at best it is an oversimplification. Counterfeiting is a global problem, and China is merely a convenient nexus.

If I expected an anti-Chinese screed when I read Illicit, I was soon disabused. Naim is reasoned, expansive, and decidedly balanced in his coverage of the problem. While not exonerating any government (he notes that often the governments, or select officials, are active participants in these networks), he notes that counterfeiting is a bigger problem today than ever because its practitioners have exploited the openness brought by globalization.

The problem of all illicit trade, he notes, is multinational. The solution must be so as well. The answer is not to chuck globalization or rake the Chinese government and police over the coals when fake Louis Vuitton bags show up in San Francisco, but to globalize the effort against the problem. In fact, by the end of the book, the only question I had left was “how many other China-related issues are we seeing through the veil of a commonly held mythology?”

Our experience with a rising China is teaching us an important lesson: not every China-related business issue need be raised to a bilateral fight with China in the middle. Some demand a new approach that turns the government into a willing ally rather than an enemy. Today, the matter of intellectual property rights is at the head of this list.

There is a movement afoot to build a case for filing a complaint against China at the World Trade Organization, alleging that China’s efforts to censor the Internet are in violation of the terms of its WTO membership, which Reuters’ Chris Buckley begins to examine here.

As I am not an attorney, I won’t comment on the law involved – I’ll leave it to Dan Harris and Stan Abrams to do that. But the law is not the only issue here. Perhaps more important is whether, even if China were to lose the case, the rest of the world would be willing or able to enforce it.

It is hard to overstate the importance that the Chinese government places on its ability to manage the content to which the broader Chinese public is exposed. The nation’s leaders would undoubtedly see a ruling that strips them of this ability as not only a commercial challenge to the local media industry, but also as a direct attack on their ability to govern the country.

In the face of such a ruling, China would have four potential courses of action:

comply, and watch the country flooded with all manner of content, including the salacious and seditious;

partially comply, opening up access to more sites but come up with ways to circumvent the ruling;

ignore the ruling, continuing to censor but risking sanctions that may provoke a trade war during a difficult economic period; or

withdraw from the WTO, replacing it with a series of bi-lateral agreements.

All of these, even the last, are on the table. There are those among China’s leaders who would view the removal of their right of censorship as a major assault on China’s sovereignty. Rather than lose one of their most important means of governance, many would sooner abandon the WTO and return to the old system of bilateral agreements, or, alternately, take the lead in establishing an alternative trading regime.

It is unlikely that the Chinese government would simply stand aside and allow the country to be flooded with everything from separatist advocates to kiddie porn, and the other scenarios would make it difficult or impossible for the ruling to make a significant difference to the commercial prospects of foreign Internet or media companies in China. Surely those planning the complaint must know this.

So the real question must be whether the motives behind this action are, in fact, commercial, or whether the issue of business access is a cover for another agenda. Given the that a commercially satisfactory result in the case is unlikely, and given that the advocates for the complaint that Reuters quotes are free speech organizations, not business groups, this action is in danger of being perceived more as a political assault against the underpinnings of Party rule in China than as a straight commercial dispute, both in Beijing and in Geneva.

If this action is to go forward, and if it is to achieve its stated aims, it must do so with commercial complainants and a very specific commercial objective. To try and accomplish more far-reaching goals with such an action, however well-meaning, risks undermining the legitimacy of the WTO and disrupting the global trading system.

Before I do my deep-dive into the small shelf of books and articles on the PRC luxury goods industry that has been growing in my library, and before the ideas of their authors start altering my own impressions, here are ten guiding principles framing the business I’ve gleaned from working with luxury brands here.

1. Even if it is dead elsewhere, “bling” lives in China

2. Today, the majority of Chinese consumers are attracted to name brand and luxury goods because of the outward statement this makes about them and their success or style.

3. A smaller percentage of Chinese consumers are attracted to luxury goods because they believe that the brands represent superior quality, materials, and workmanship.

4. An even smaller percentage are identity consumers, who patronize a brand because it has become a part of who they are. These people, who have evolved beyond simply showing off and who expect quality as a given, patronize a brand because they could not imagine it otherwise.

5. Pre-lux brand customers are interested in buying brands but lack the wherewithal to do so. These are the biggest buyers of knockoffs, and some of them (but not all or most) will eventually buy the real thing.

6. Be aware of the post-lux consumer. This is a consumer who can easily afford luxury goods, has a clear understanding of value, understands that value and style can be had for less money.

7. There is also the inconspicuous lux consumer. They want the quality and value of the brand but do not want – or fear – ostentation. Coddle them.

8. Company owned brand flagship stores are an essential part of establishing and building luxury brands in China. Not only do they provide an opportunity to experience the brand, its values, and its lifestyle, they also offer an place where consumers can be assured that they are procuring a genuine product.

9. Flagship stores are an advertising expense. Think of them that way, and worry less about actual sales.

10. Often consumers will be travelers or will have the wherewithal to travel internationally. You will sell to them in China but they will buy overseas to avoid import duties. Track them aggressively to ensure their sales are credited against your marketing in China.

In conducting my technology and intellectual property rights (IPR) panel with the Notre Dame Medoza b-school students last week, I realized in the midst of Eric Priest’s comments that the problem of IPR protection in China was too often painted as a two-dimensional issue.

Laws, cops, and jails

The first dimension is law, or the extent that China has on its books the statutes, treaties, regulations, and administrative procedures to protect patents, trademarks, and copyrights. I’m no lawyer, but I defer to the three attorneys on my panel (two of whom were Ph.Ds) who seemed to agree that the legal structure to protect intellectual property rights is in place in China.

The second dimension (and the one that gets all of the attention) is enforcement. Okay, China, the world seems to say, you have all of these wonderful laws to protect intellectual property of all kinds. So why are companies, individuals, and institutions violating these laws everywhere in China with seeming impunity?

And here we have the problem. The lawyers, organizations, and government negotiators fighting to protect intellectual property rights in China are focused on getting more cops to shut down more factories, arrest more people, jail them longer, fine them more, and prove to the rest of the population that messing with intellectual property law is a ticket to jail. They use that old logic “kill one to save a hundred.”

As much as it might enrage some of those defenders of intellectual property rights to say this, there are not enough cops, jails, or judges in China to end the problem purely by judicial means. (In fact, I’d suggest that even in the most developed societies, the tools of enforcement were only ever meant to be used in the relatively rare cases of overt, commercial violation of patent, copyright, and trademark laws.) And there never will be.

“Both domestic and international entertainment companies have tried the litigation path in China with little success. Major Chinese search engines like Baidu.com and Yahoo.cn have deep pockets and are far and away the most popular channel for accessing free music files online in China, so they were natural targets for contributory infringement suits. But murky legal issues (Baidu won on appeal because the court found it only aggregated links to content but did not in fact serve the content itself, while Yahoo.cn was found iable for infringement under similar circumstances) and notoriously low damages for infringement available under Chinese law have left copyright owners with little recourse, and emboldened internet companies to continue to conspicuously serve up free, unlicensed content.”

Eric suggests that the better approach is to create business models that ensure compensation for the artists and labels as well as the company profiting from their distribution. In the paper he lays out three potential business models that could be used in China. Without doubt, new models need to be created, tested, revised, and perfected, and therein lies a major part of the opportunity.

The problem with the model approach is that any new model hoping for adoption must deliver a experience that is superior for the consumer to the model it is replacing. A painful number of models fall short of that promise. Some of the largest companies in the world have failed to deliver a superior book-reading experience on a mobile device, and the jury is still out on Amazon’s geographically limited (and still expensive) Kindle. Conversely, home video has taken off because it offers an experience that is in many ways superior to the cinema. And iTunes turned music downloads into a mainstream experience.

In China, technologists cannot stop at creating business models that satisfy the music supply chain: they have to offer something that is so much superior to free music that people will be willing to pay for it. And then the people will need to be sold. Ask Steve Jobs: even the best experiences in the world don’t sell themselves. For all of its virtues, Apple had to market the hell out of the iTunes experience to drive uptake beyond an initial core of users. Success for any business model will require a greater effort still.

Win their hearts and minds and their wallets will follow

Which brings us to my point. As much as lawyers may wish us to believe that law and enforcement should be adequate, as much as engineers may wish us to believe that technology offers a silver bullet, as much as entrepreneurs believe that smart models are the solution, they are all ignoring one more important piece:

Compliance. Voluntary compliance.

I’ll put that in short words: people have to want to do the right thing. Then you have to give them an opportunity (business model.) Then you have to make non-compliance inconvenient (DRM, or something better that replaces it). Then you have to make breaking the law downright costly (laws/cops/courts/jails/fines). You need every element in that chain if IPR is ever to have any value. Because you can put all of the technical and legal solutions in place that you want, but until you have convinced the consumer that compliance is in his best interest, too, he or she will find ways around it.

You make it personal. You make it meaningful. You make a civic and more importantly a social virtue out of compliance. You make that individual feel like he or she is doing something important every time they lay cash down for something they could get for free. No. I will not do that. It’s not right.

Is doing that going to be easy? Absolutely not. This is what management texts refer to as “a big, hairy-assed goal.” But the industry uses the size of the task to justify not undertaking it. They tell themselves “it is too hard. You cannot change Chinese culture, and anyway it is easier and cheaper to hire more lawyers and get our industry associations to talk smack about the Chinese government in congressional hearings.”

Yes, it will be a long, difficult, and costly process, but so is the current effort to push for enforcement. The industry has spent millions pushing for better laws in China. It is spending tens of millions on enforcement and litigation. How much is it spending on getting people to want to pay for something they are used to getting for free?

It may take a generation or more to change the way people behave. But it can be done, and it must be done if artists – songwriters, composers, and performers – are ever to have a trade in China, and if the music business as a whole is ever to thrive.

The panel was made up of myself and three speakers, all of whom were accomplished attorneys. I have to admit to being worried about that before getting there, but it turned into probably the most dynamic public discussion I’ve heard on the topic in ages. We never got sucked into a China-bash, but kept things focused on how you protect your IPR in the face of “what it is” in China.

All three speakers acknowledged that after three decades and an China’s IPR laws are in place, so James Luo from Bird & Bird dove into why enforcement in China is possible but not easy. James is a great speaker, and a nimble opponent when questioned. I tried to corner him with a question about how collusion between local IPR violators and enforcement authorities undermines efforts, and he dodged the bullet with grace and humor.

The other full-time attorney on the panel, Ray Moroney of Rouse & Co., focused on prevention as the best cure, underscoring that IPR protection begins long before your business arrives in China. Of all of the foreign IPR attorneys I’ve met, Ray is perhaps the most commercially-minded of the bunch. He told the group that you cannot come to China with a fixed business model around your IPR – you have to think creatively. I’d rate him as more than just an attorney, but a true counselor on the subject.

The third speaker was Eric Priest who, while an attorney by training, has given up on the practice of law to actually dive into business. He is involved in a couple of ventures, notably Noank Media, a global music licensing concern. Eric is one of a growing breed of what I would call merchant-scholars, people who combine serious intellectual pursuits with entrepreneurial tendencies. Eric actually put the whole discussion in a broad business context, explaining that China does not have just one intellectual property problem, but several.

The Takeaways

The underlying messages that the students took from the hourlong program (just before they jumped on buses to go look at the problem firsthand in Zhonguancun and the Silk Market) confounded the impressions they had taken from the media at home, to wit:

The IPR problem in China is much more complex – and nuanced – than it is often presented by western media and the various industry players and lobbyists for whom this is the issue;

You have to think creatively about solving your IPR issues: lobbying, factory raids, and lawsuits alone do not an IPR strategy make. You have to rethink your business models, your business structure, and your entire regime for protecting proprietary information when coming to China;

Intellectual property protection in China will make only limited progress until local enterprises and institutions are suffering from counterfeits and piracy at least as much as foreigners are. In the meantime, Hu Jintao probably does not wake up every morning worried about IPR issues.

No surprises for the initiated, to be sure, but one more indicator that much of the problem in the fight over intellectual property comes from the way executives, pundits, and policy-makers abroad perceive and frame the problem.

I walked away with a few other conclusions, but that’s the subject of another post.

The Students

The 46-odd students in the group were primarily executives working with some of the largest firms in the U.S. After a few days in China it was pretty clear that they were reaching that stage of sensory and mental overload as they tried to absorb it all. At the same time, I didn’t see the distant stares that usually accompany such whirlwind immersions. These students were all really jazzed about China and wanted more.

If I were a cynical person, I would suggest that any MBA student looking at the prospects for a robust US job market after graduation would be wise to be interested and enthusiastic about opportunities overseas. But it was not like that. It was more like they sensed something in the air – opportunity, maybe, or post-Olympic optimism, or perhaps that hum that you feel more than you hear when you land in China.

I suspect most of them will be back, and soon.

*(I will resist the temptation to create an acronym around “free and open culture movement” for fear of pronunciation issues)

Galen Gruman at IDG publication InfoWorld has done the technology industries a community service, building a petition signed by 100,000 computing industry professionals imploring Microsoft to continue selling Windows XP after June 30, the date Microsoft plans to remove the older version of its personal computer operating system from the shelves. Getting 100,000 IT professionals to do anything together without the incentive of a free t-shirt, free software, or an opportunity to meet females is quite a trick, so IDG’s survey is an illustration of how emotional this issue has become for those of us not using some flavor of Linux or Mac OSX (our favs here in the Hutong).

At least, it is an illustration of how emotional this has become outside of China.

While I am certain Microsoft CEO Steve Ballmer would say that the (relative) lack of uproar in China about the impending forced-march upgrade to Vista is due to the fact that Vista is the most loved OS in China’s history, I beg to differ.

I would say piracy is the reason for the silence.

Jack Sparrow, Vista Killer

People are somewhat less worried about the availability of Windows XP in China because they know that XP will be available here for as long as anyone wants, and for a very small price. (Without Microsoft support, certainly, but available.)

Microsoft has made tremendous progress against piracy in China over the past several years. The problem is far from beaten, but the company has more than doubled the percentage of people paying for their Microsoft software.

But by taking Windows off the shelves, Microsoft appears to be creating a perverse incentive for people who might otherwise buy legitimate software to resort to piracy. Indeed, Microsoft appears to be creating the ideal conditions for a thriving market in illicit copies of Windows XP after June 30, and not just in China.

Certainly, Chinese users who prefer Windows XP to Vista will have few compunctions about turning to one of the thousands of enterprising vendors to be found on our city streets for a budget-priced DVD if they cannot find it in legitimate places, like Federal Software or on the hard drive of their new computer.

But it won’t stop there. Microsoft is almost inviting China to play a leading role in the global anti-Vista backlash. Imagine, if you will, hundreds, even thousands of visitors passing through China during the Olympics, picking up a copy or two of XP to take home.

Imagine IT consultants all around the world continuing to install those copies of Windows XP in new computers – for a service fee.

Imagine computer dealers and manufacturers offering (nudge nudge, wink wink) to install XP in the new computers as an option. It will certainly happen here in China.

Imagine a thriving online marketplace in downloads of Windows XP.

It will happen. Commerce, like love, will always find a way.

What Microsoft would kill, pirates will revive – and sustain.

Inviting a Challenge

In fact, the issue is already causing many people here in China to wonder whether there is a legitimate principle (under fair use or some similar legal tenet) that wokuld support enterprising merchants who wish to sell – or give away – copies of a software product for which there is a continued, legitimate demand after the manufacturer has removed it from sale.

We in the Hutong are no fans of IP pirates, nor are we particularly fond of people who break any law because compliance is inconvenient. We remain firm believers that creators of intellectual property have the right to be rewarded for their efforts. We believe that if you disagree with intellectual property (IP) law, the proper response is not to ignore the law, but to change the law or challenge its underlying principles.

By pulling XP from the shelves when people still want to buy it or use it merely to compel people to spend more money on (what they believe to be) an inferior product, Microsoft may be opening a legal can of tubular invertebrates, if not in the U.S., certainly in China.

The root of legislation is perception, and the perception that Microsoft may be taking advantage of intellectual property laws to hold users over a barrel may be just enough to incite a legal challenge in China not only to Microsoft, but to the core of the relatively young body of law protecting the rights of software companies.

The logical principle is this: if Microsoft stops selling an IP-based and there is still a market, could a case be made that Microsoft has abandoned the product, and that the law should allow for someone else to sell it?

Even Galen Gruman, no man’s idea of a socialist, suggests in his InfoWorld article that the very ubiquity of Windows has made it a public good supplied by a private entity, thus subject not to the normal system of rules regulating commerce, but to those principles that govern utilities like the power grid, phone service, and air transport. Galen’s implication is that the Windows case calls for a suspension of normal rules, if not direct government intervention.

Policy makers in China, who have long watched Microsoft’s growing power with consternation, will likely at some point join their counterparts in the European Union as activist watchdogs over Redmond’s global business practices. Stung by what they see as the America’s overenthusiastic use of intellectual property law to protect its creative an innovative companies, the Windows XP issue may well provide the high ground for China to take a stand against a flawed body of intellectual property laws imposed on China by its WTO accession.

That’s a slippery slope.

Thinking Beyond Vista

No doubt Microsoft wants Vista to succeed. What worries me is that the company’s leaders may well have convinced themselves that Vista must succeed for the company to survive.

It is time for Microsoft’s leadership to take a step back and ask themselves if killing XP to save Vista isn’t a step too far, and to recognize that the unintended consequences of their efforts could have a far more deleterious long-term effect on the company’s prospects than would the failure of Vista (and the continued success of XP).

Steven Schwankert of Village Grouch fame wrote an excellent piece for IDG (picked up here in The Washington Post) describing how Chinese fans seeking to download illegal copies of Ang Lee’s excellent film “Lust, Caution” are finding on their hard drives not a copy of the film, but with software that pops a nasty little trojan virus into their systems.

There are several interesting aspects to this story.

Virus? What Virus?

First, it was apparently found and addressed by Kaspersky Lab and Rising Software well before it came up on the collective radar screens of Symantec, McAfee, and TrendMicro. One wonders why this is the case, particularly given that Symantec and McAfee tout the value of their software in part based on their global scanning for viral threats. I am especially concerned about TrendMicro, who have a huge presence in China and who make a great deal about their expertise as an “Asian” security company.

It also suggests that the malware threat in China is growing and diversifying. From dorm rooms filled with budding software engineers, to the challenges facing the country’s law enforcement teams, to the quiet but rapid growth of China’s cyberwar military-industrial complex, the country has become as much a haven and spawning ground for creators and distributors of Malware as the United States or any other country. This would seem to argue for greater investment by the computer security vendors in local labs who can not only find but anticipate new threats.

As an aside, it would also seem that companies like Symantec are destined to become major defense contractors. But we digress.

The Empire Strikes Back

Second, it seems that Hollywood (including the music and TV people as well as the film side of the business) and the software industry may have inadvertently discovered a way to slow online piracy and perhaps even the growth of downloaded content. All the studios – or, better yet, the MPA and the Business Software Alliance – need to do is hire a few good hackers to come up with some particularly nasty viruses and spread them around online disguised as illegitimate digital copies of random applications, movies, and music files.

Sure, the viruses would not deter the most determined or careful downloaders, and the anti-virus companies would inevitably come up with fixes. But imagine, for a moment, the fear, uncertainty, and doubt this would wreak among the less-expert. The mere possibility that these files would include viruses would be enough to drive a lot of marginal downloaders away from illegitimate downloading (and probably a few away from legit downloads as well).

Naturally I would expect clearer heads in the PR and legal departments of these organizations to prevail, ensuring that neither Hollywood nor the software industry would ever actually subsidize – or even publicly condone such practices. But you can easily imagine how such an option must tempt some people in places like Redmond and in the Black Tower.

Indeed, if the matter of digital rights management has proven anything, it has proven that Hollywood and many large software concerns believe that extremism in the defense of intellectual property is no vice, and that goodwill is readily sacrificed in that battle. If anything will keep hackers from high-powered lunches at the Ivy or the Fulton Fish market, it is the fear of court costs.

Nonetheless, it is fascinating, if not a bit disconcerting, to think that there is a commonality of interest between the creators of malware and the creators of movies.

Engineer, Engage the FUD Pump

What I do expect is that the IPR-driven industries will kick into gear a semi-coordinated propaganda effort to ensure that stories like the “Lust, Caution” become as widely known as possible, so that the threat is seen as being far larger and more serious than it really is. This costs them little, supports their goals magnificently, and enables the studios and developers to position themselves as defenders of the public interest.

Which, frankly, is the smarter way to handle it. You steal, you pay. Or, you pay, we protect.

For all the failings implicit in Hollywood’s approaches to the IPR issue and digital entertainment, let’s not lose sight of the most important fact – downloading illegal files is theft, theft is wrong, and anyone who does so willfully probably deserves a hard drive filled with malware.

He and I are often in general agreement, and I enjoy reading his stuff. In this article, he’s touching on one of my favorite themes: an economic approach to reducing the size of the piracy problem will beat a moralistic approach any day.

For the sake of advancing the argument rather than denigrating Shaun’s excellent piece, I want to call out one issue that his article brings to light.

We Got 99 Problems But The Law Ain’t One

Shaun’s article is broad, covering almost the entire issue of IPR theft in China, including pirated software, counterfeit luxury goods, knockoff pharmaceuticals, tainted food, bootleg DVDs, and fake consumer electronics. It is a perfect example of one of the unspoken reasons we have not managed to solve the IPR issue in China yet: we have collectively failed to recognize that each of the manifestations of IPR theft is a separate, distinct problem with its own causes and solutions causes us to search for simple solutions.

We need to recognize that China does not have one gigantic IPR problem, but several quite large IPR issues that each need to be addressed separately.

For a simple example, let’s compare bootleg DVDs and knockoff pharmaceuticals. Consumers are complicit in the first. They are unwilling victims of the second. What drives these two issues are quite different: in the case of DVDs, it is a combination of price arbitrage (“it’s too expensive to buy the real thing”) and failed distribution (“I want the real thing, but there’s no place I can buy it.”) In the case of knockoff pharmaceuticals, the problem (as I understand it) is a combination of lack of awareness, profiteering medical administrators, and a distribution system that mixes the real with the fake.

The problems are different, the solutions should be as well.

The old saw about how to eat an elephant (“one bite at a time”) applies here. Fix the problem by breaking it up into its component parts. Create solutions for each type of piracy one at a time.

Your Mercedes or My Life

As an aside, we must also recognize that some piracy issues are more serious than others. Motion picture and software piracy are bad things, and we focus on those issues in The Hutong because they’re close to our heart. Pirated copies of Windows VISTA and Terminator 3, on the other hand, are not likely to kill people the way, say counterfeit aircraft parts, pharmaceuticals, or batteries might.

As we disaggregate the piracy problem, we could all start spending a little more time focusing on the parts of the issue that are potentially lethal but not quite as glamorous.

Where The Law Does Matter

As Shaun himself appears to grant in the last paragraphs of his article, engaging on the legal/moral side does have value. There are two important qualifications to that. First, the victories Shaun cites are Chinese companies suing Chinese pirates. These cases, which cannot be framed in “us vs. them” nationalistic terms, are superb examples of why the battle in the courts is best framed with Chinese as the plaintiffs rather than foreign ones.

Second, these victories come not to companies who abstain from full participation in the market, but those who focus first on gaining full and legitimate access to their customers in China. Apart from the fact that this makes great business sense, it recognizes a often overlooked phenomenon: when a foreign company builds access to its customers in China, it automatically enlists a host of de facto allies in its fight to defend its IPR: Chinese companies who serve as partners, suppliers, distributors, retailers, promoters, developers and the like.

Legal and commercial tools to protect IPR march hand in hand. But the commercial means must be applied first, the law second.

Hollywood, take note.

Our Greatest Ally

At the core of Shaun’s argument – and mine – is that we have to look beyond the government for solutions. Even if the government woke up Monday morning and said “okay, let’s fix the IPR thing,” they would not be able to achieve a solution via fiat. They will turn to industry – us – and say “okay, given the limitations on our police resources, how do we create a lasting solution to the issue?”

We’d better have some smart, specific, commercial answers, and we be ready to mobilize our greatest assets in each fight: the ordinary Chinese who are being hurt by each specific form of piracy. Consumers, businesses with their own IPR, filmmakers, and the companies who rely on legitimate foreign IPR or IPR-based products for their livelihood. Only can the battle be won on the streets, and only then will the politically controlled police and court systems recognize the value of consistent, vigorous enforcement.

In the Hutong
Mixing a cold cocktail of one part disgust, one part mirth, and three parts burnout
0016 hrs.

So the world has discovered that Beijing has a theme park that significantly knocks off Disneyland. While park executives deny any relation to Disney, the place’s tagline is “because Disneyland is too far.”

Here’s a thought: what hope is there of having the government shut down pirates in the provinces if they’re allowing a state-owned enterprise knock off an entire theme park right in the nation’s capital?

The government will not help IPR property owners as much as they can help themselves. Focus on building a path to your customers, then go after the miscreants. You’ll have a better shot at moving the enforcers to action when your enterprise is employing people and paying taxes, too.

Mark Shuttleworth is a can-do, solutions oriented kind of guy. I greatly admire what he is doing (making Linux, formerly The OS Only A Geek Could Truly Love, into The OS that You Can Love if You Hate Windows But Can’t Stomach OS X). Truth is, I’ve got Ubuntu running alongside OS X on my Macintosh for no better reason than to support what Shuttleworth is doing.

What I would have expected from someone with his entrepreneurial drive and technical acumen is something more than “DRM sucks – deal with it, entertainment business.” I would have hoped he’d at least start to focus on possible ways for artists – and maybe a few entertainment companies – to continue making a living in a world where they’re being asked up their last stitch of property protection.

No Pay, No Play

Nobody really likes DRM. Nothing pisses me off more, for example, than the fact that all of the DVDs I purchased in Australia are unreadable on my region 1 encoded computers. Note, if you will, that I (or someone) paid full retail price for every DVD I own. I’m fine with not buying pirated DVDs here in China, and I’m even okay with avoiding DVD shops here because you really never know what’s legit and what isn’t. But I’m pissed off that if I go to an HMV in Hong Kong or Singapore or Japan and buy legit DVDs there, I can’t play them.

But I understand why those things are there. And I also understand that if you walk up to an artist or an entertainment executive and say “look, you need to throw all of your work out into the public domain, like shareware, and put everyone on the honor system to pay for it,” they’re going to throw you a right hook, and rightfully so.

Stop the Posturing

When people get scared – or feel threatened – the automatic reaction is to put the wagons into a circle, or create what the voortrekkers of Shuttleworth’s native South Africa once called a laager. The entertainment business is scared. The wagons are in a circle, the lawyers at the ready.

What needs to happen is for somebody with vision and intelligence to step forward and start talking about transition, a way to put the entertainment industry on a path to wean them from DRM, but at the same time to come up with other stuff that lots of people will pay for around the music, television, film, and other works that are no longer protected.

There’s going to be no silver bullet. It’s going to be a lot of different business models in the end, but you aren’t going to get from here to there by waving a scary future in the face of everyone in the entertainment industry around the world.

Great post, Mark. Nice Op-Ed, Steve Jobs. Get DOWN on your bad selves.

Now, enough with the posturing – and that goes double for the suits at the RIAA and the MPAA. It’s time to start building bridges to the future.

Interesting little article in EETimes late last week. It seems British semiconductor startup picoChip opened a networking and communications R&D lab at Beijing University of Posts and Telecommunications (BUPT) last week.

All very interesting, as picoChip is basically outsourcing its R&D on 4G wireless technology. With too few hands and too much ground to cover in the world of wireless, picoChip apparently figures it’s better to have to outsource than not to be in the game at all. This points to an important trend: global R&D in China is no longer the sole province of Fortune 1000 technology beheamouths. A broad range of companies, often driven by expatriate Chinese executives, is coming to China to tap the country’s technical labor resource.

What concerns me about the tone of the article is that a mere 7 days after setting up shop, EETimes makes it sound like picoChip has licked all of the major challenges one faces when coming into China and that the place is already showing great results.

On IP protection: “There’s some risk – IP protection is always a concern in China – but picoChip Chief Technology Officer Doug Pulley said so far he has seen only upside.”

This after “a couple of small-scale projects with BUPT” and a week in operation. Let’s see. Tiny startup in Bath, England working in China with a major Chinese university under the wing of the Ministry of Information Industries. Am I the only one who sees the Bambi-meets-Godzilla IPR risk here?

Good luck, picoChip. Really. I hope this turns out really well for you. I also hope you’re going to put some very senior people from Bath on the ground here permanently to oversee things at the lab. And I hope you’ve got outstanding legal advice.

UPDATE: In a superior example of corporate conversation, Rupert Baines picoChip’s vice president of marketing, left us a comment (see below) clarifying a few critical facts that were not evident in the article in EETimes:

1. The lab is to create enabling software only, not do chip design.

2. picoChip’s core IP remains separate from the lab.

3. The work BUPT does is only peripherally important to picoChip’s core business.

Okay, so it probably isn’t all THAT early to be giving everyone high fives. In fact, I’d go far as to say picoChip has structured their venture with BUPT with savvy and intelligence.